He comes with over 20 years of research experience in the areas of macro economies and financial markets research, including equities, fixed income, commodities and currencies. Sinha has successfully extended his macro research work towards application-oriented themes covering automotive, rural, and real estate sectors among others.

There are more reasons for this market to fall than rise; find out why

Expanding valuations for midcap and smallcap stocks have had a capillary action.

ET CONTRIBUTORS|

Updated: May 05, 2017, 04.48 PM IST

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Despite some pickup in earnings in the second half of FY17, full-year aggregate earnings for both Nifty and Sensex are likely to end up flat.

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The disquiet over valuations in the domestic stock market is on the rise, with the benchmark indices scaling all-time highs even when patchy corporate performances fail to support the valuations.

Despite some pickup in earnings in the second half of FY17, full-year aggregate earnings for both Nifty and Sensex are likely to end up flat. These bellwether indices have rallied nearly 75 per cent since mid-2013 despite stagnant profits over the past three years and this is a cause of concern as the trailing price-to-earnings (PE) ratio has risen to a high of 22 times.

Midcap stocks have seen an even stronger surge, rising 180 per cent with the trailing PE of the BSE Midcap index now at 34 times, again not supported by commensurate improvement in profit performance. Expanding valuations for midcap and smallcap stocks have had a capillary action by pulling in flows from investors, thereby reinforcing stretched valuations.

The impression that the market is possibly distorted in the context of its fundamentals reflects in multiple indicators. The zero earnings growth for the Nifty50 companies since FY14 is worse than the average 4.5 per cent growth since FY08.

But historically (prior to 2010), multiples of 20-22 times were supported by consistent EPS growth of over 25 per cent. The current trailing PE multiple of 22 times is nearly 33 per cent higher than the long-term average of 16.5 times.

Secondly, the ROA of Nifty companies has declined consistently to 2.5 per cent from a peak of 6.5 per cent seen in 2008 when valuations were at 22 times.

Thirdly, assuming India’s real GDP growth at around 5 per cent on the earlier 2004-2005 series corresponding to 7 per cent as per the new series (long-term average for the new series 2012-13 is unavailable), the current PEG stands at 4.4 times, which is even higher than 3.8 times during the dot com bubble of 2000-2001 and an average of 1.8 times during the high growth period of 2004-2008 when GDP growth averaged at 9 per cent and corporate earnings were compounding at 25 per cent.

So why should the market sustain in a perpetual overvalued zone? The common logic is that markets are forward looking; hence the role of forward consensus earnings projections is critical.

Currently, one-year forward consensus earnings growth for the Nifty50 companies is 25 per cent and with this, one-year forward PE at 18 times looks somewhat reasonable. However, consensus earnings projections have had a dubious track record. Over the past nine years, virtually for each year, consensus earnings growth for Nifty50 started off at 15-20 per cent but ended up being significantly downgraded. Thus, the actual earnings CAGR has been modest at 4.5 per cent since FY08. Clearly, there has been no learning from the past and perversely, it appears that earnings projections have been catching up with stock prices.

The other aspect worth acknowledging is that India’s robust GDP print of 7-7.5 per cent as per the latest series is starkly in contrast with weak corporate earnings performance in recent years.

The answer to market being in a prolonged overvalued zone probably lies in three distinct factors. One, central banks, led by the US Fed, have been pumping up asset prices by actively depressing risk-free rates and market volatility to compensate for lack of earnings growth. The collateral surge in flows into emerging markets, including India, also resulted in asset price misalignment with fundamentals.

Secondly, the expectation of earnings growth has been kept alive by consensus forecast.

And thirdly, from an Indian perspective, domestic flows of retail investors into midcap stocks and funds have sustained over the past three years.

Our assessment of the global scenario suggests the problem of overvaluation is prevalent across most global equity markets, both emerging and developed. For instance, EPS of world MSEI Index has contracted at an annual rate of 1 per cent in last six years while the index PE has expanded 45 per cent. Likewise with an annual contraction in EPS of 1 per cent for developed economy MSEI, the PE multiple has expanded 40 per cent while for emerging markets the MSEI EPS has contracted 6.5 per cent annually even as the PE multiple has expanded 20 per cent.

US S&P 500 Shiller cyclically adjusted PE (CAPE) at 29.38 times is 75 per cent higher than the average since 1871 and pre-2008 crisis level of 27.5 times.

This precarious balance between valuations, earnings growth and risk-free rate is critical for financial markets. The point is that all these variables are displaying crucial attributes – risk-free rate at historical lows, multiples at historical highs and earnings stagnant.

But this benevolence is unlikely to sustain for long, as recent developments indicate bottoming out of the risk-free rates with the Fed rate normalisation now entrenched; the US Federal Reserve is preparing to taper its bloated $4.5 trillion balance sheet and a decline in surpluses in emerging markets has resulted in reduced official demand for US treasuries. Importantly, global portfolio flows into emerging markets have become less consistent since the end of the US Quantitative Easing in 2014.

The sustenance of market exuberance is pivoted on ability of the central banks, especially the US Fed, to normalise the overly accommodative monetary policies without letting the risk-free rate inch up faster than earnings growth. The good news is that earnings appear to have bottomed out sometime in 2014-15 along with the revival in commodity prices and improved momentum in major developed economies.

Within the emerging markets space, consensus estimates expect earnings revival led by China, Korea and the technology sector. Russia has demonstrated a comeback in earnings following the 2014 shock. In an ideal world, a goldilocks scenario of growth revival, moderate inflation and gradual rate normalisation is essential for the markets where valuations are already much stretched.

But things can become tricky. For one, a faster rise in inflation due to either rise in commodity prices or sudden overheating can invite swifter rate hikes by the Fed, thereby triggering a meaningful correction in market valuations.

Secondly, a combination of fiscal expansion and trade protectionism can further constrict global saving surpluses in emerging markets, resulting in higher interest rates and inflation. And three, the risk of earnings recovery is failing to sustain beyond the near term.

Clearly, while concerns on valuation are real, absence of an immediate normalisation trigger can bate the market into enlarging the current exuberance further.

From India’s stand point, as long as the global normalisation trigger remains at bay, the Indian market will likely to see continued investor interest getting relayed into areas that reflect valuation gaps. India appears to be heading into an upturn on the back of growth recovery in advanced economies, fiscal expansion by state and central governments with larger focus on entitlement schemes focused on rural and agricultural sector stimulus, better retail demand and normalisation of the impact of demonetisation over the coming quarters.

The risk from India’s stand point is that the requisite adjustments for a sustainable growth recovery are still not in place. For instance, the banking sector has still not acquired the counter-cyclical buffer to support growth.

India’s savings rate has still not picked up despite an earlier decline in commodity prices. A faster pace of retail lending and consumption and weak compensation growth indicate a decline in structural portion of household savings.

Productivity of capital is still sub-optimal for private investments to revive. And inducement of fiscal stimulus focused on various entitlement schemes ahead of private sector growth indicates shorter fiscal multiplier effect compared with earlier periods.

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)